A small little dye manufacturer

This company has a market capitalization below 40 million, it would be an understatement to call it small. People tend to avoid small cap stocks because of the psychological effect of dogma that the bigger companies are more stable therefore smaller companies are the opposite, less stable. That may be true to a certain extend but it is because of this thinking that brings us opportunities due to exceedingly low pricing for them.

A substantial shareholder, above 20%, has started to liquidate their holdings. You would look at this and strike off this company from your mind but let’s ask why? Obviously because the company has been losing money for the past 3 years. If we take a more objective view, we would realize that they have not been profitable because of the business environment, the textile industry has not been doing well and other companies are also facing the same problem. If this is a business cycle, is it fair to analyze this company in the bad years? Maybe we want to be looking at the company performance in both good and bad years. So when the good years do come, which it will, we have a reasonable idea of it’s earnings.

Now with this assumption, why would the substantial holder still decide to sell then? Well it may because of the institutional imperative. They are forced to sell because they have to report profit annually, so when their investments are making a loss every year it affects their performance appraisal and their jobs are in danger. This pressure the man in the institution to sell. When you have a large supply of shares selling in the market, more than the demand you get a lower price. We have micro economics principle working in our favor right now.

Next let’s look at the management. The founder has just been handed over the responsibilities to his son, who is around 30 years old, but still remains as the chairman of the board. The company has entered the Chinese markets in the 1990s but did not perform well. What caught my attention was when the chairman admitted that their mistake during the china expansion was their products were being copied and sold in competing market driving their margins down. Here the problem arises because they didn’t protect their trade secret, the formula to make their chemicals. Just this mistake caused the company 2 decades of poor performance. I believe now the son will not make the same mistake, he will protect his intellectual property more than his father did. Being headquartered in Singapore will allow them to do just that, with a strong code of law and intellectual property law all the R&D can be protected here while the non key process done in emerging countries. It is hard to find a undervalued company with a potential economic moat around it. If the young executive director works hard with gusto and puts his youthful energy into the company reinvesting into research & development, this company might have the slightest chance to become an innovative chemical company and not just another small manufacturer of less advance chemicals.

So we have this company selling 50% below net current asset value, then we have to ask the question: Is this margin safe enough for the possibility of becoming a company with an economic moat that won’t make the same mistake of letting it’s products be copied easily?

Of course we have to also look at the unfavorable case scenario: If nothing promising comes out of this company, the least would be the business cycle will drive the earnings to profit when the economy picks up speed and very possibly sell when price appreciating to 100%(net current asset value) which is double your capital invested.

In conclusion, to put my reasoning into a checklist;

• Management[Pass]
• Recent Earnings[Fail]
• Economic Moat[Pass]
• Net Net[Pass]
• Margin of Safety[Pass]
• Price[Pass]